Fed Unveils Tapering Plans, Tweaks Forward Guidance

The Federal Reserve on Wednesday, citing a healthier U.S. economy, announced the beginning-of-the-end of its unprecedented easy-money stimulus programs initiated in the wake of the 2008 financial crisis.

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The policy-setting Federal Open Market Committee voted to start gradually reducing its $85-billion-a- month bond purchase program known as quantitative easing by $10 billion a month beginning in January.

“In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to modestly reduce the pace of its asset purchases,” the Fed said in a statement released at 2 p.m. ET.

Stock markets soared on the announcement. The Dow Jones Industrial average climbed more than 200 points in the two hours following the announcement. The Dow closed up 292.71, or 1.84%, at 16167.97 and the S&P 500 rose 29.65, or 1.66%, to 1810.65, both new highs. And the Nasdaq stock market closed up 46.38, or 1.15%, at 4070.06.

The dollar climbed to a five-year high against the yen and rose against all other major currencies. Treasury yields fell.

In an effort to balance concerns that the Fed plans to shut down easy money entirely, the FOMC pushed back the time-frame for when it will begin raising interest rates. The Fed said it expects to maintain interest rates at historic lows “well past the time” when the unemployment rate falls below its target of 6.5%.

“The Fed didn’t want to reduce the overall level of stimulus that it is providing to the economy. It simply wanted to exchange a stronger commitment to low interest rates for less bond buying. Early indications from markets suggest that the Fed has successfully engineered this switch,” said Paul Edelstein, director of financial economics at IHS Global Insight.

In a press conference at the end of the Fed’s two-day meeting, Chairman Ben Bernanke said the central bank will remain “accommodative” as long as the economy needs a boost.

But Bernanke said the economy has fulfilled a criteria set for it by Fed policy makers when they initiated the most recent bond purchase program in September 2012. Namely, “substantial improvement” to U.S. labor markets, he said.

Dan Greenhaus, chief global strategist at research firm BTIG, called the asset purchase reduction “a bit of a shock,” and described as “somewhat surprising” the Fed’s decision to cut $5 billion from its Treasury purchases and $5 billion from its mortgage backed securities purchases for a total of $10 billion.

“Unsurprisingly, the statement indicated that if things continue to unfold as expected, additional reductions are forthcoming,” Greenhaus said.

The move to scale back asset purchases incrementally rather than all at once was widely expected.

Peter Cardillo, chief market economist at Rockwell Global Capital, predicted before the FOMC’s statement was released that the Fed would taper incrementally and that stock markets had already taken the reduction into account.

Stocks have soared under the Fed’s stimulus programs, as investors have taken excess cash created by the central bank’s asset purchase programs and historically low interest rates and poured it into riskier securities such as equities.

Cardillo said the decision to taper sends a message from the Fed that the central bank believes “finally the economy is beginning to run on all gears … that the economy is doing well and doesn’t need help anymore.”

The first bond purchases were initiated in late 2008 as the global economy teetered on the edge of collapse. The purpose of the asset purchasing program was to create liquidity in credit markets, which had basically shut down that fall.

Since 2008 the Fed has increased its balance sheet through monthly asset purchases to nearly $4 trillion from less than $1 trillion five years ago.

The case for scaling back QE sooner rather than later included a reduction in the unemployment rate from 7.8% in September 2012, when the Fed initiated its latest round of bond purchases, to 7% in November as the economy added 2.3 million jobs in that 14-month period.

The Fed has made it clear that a healthy labor market is its top priority and its stimulus programs – QE and near-zero interest rates – were designed to spur lending to create demand for goods which will in turn generate jobs. How successful the programs have been remains an open question.

Also Wednesday, the central bank said members of the FOMC lowered their view on where the unemployment rate will land over the next few years. FOMC members now see the unemployment rate ranging from 6.3% to 6.6% in 2014, compared to a September estimate of 6.4% to 6.8%.

Furthering the case for tapering, the nation’s GDP (gross domestic product) growth has accelerated in 2013 and last week’s bi-partisan budget agreement in Congress, which eliminates some mandated budget cuts known as sequester and could preclude additional budget standoffs for a couple of years.

In addition, November housing starts rose to their highest level in nearly six years, providing more evidence of strength in a sector at the heart of the financial crisis. Housing starts also impacts the key construction sector, which boosts employment.

The Fed surprised markets in the past with their policy announcements, notably in September when virtually everyone believed tapering would begin. But the Fed maintained easy money.

Then tapering moved further off the table when Congressional bickering shut down parts of the government in early October and raised the threat of a U.S. default, and the September jobs report, released three weeks late because of the shutdown, was disappointing. So it was no surprise when the Fed held off again after its October meeting.

The two most recent labor reports for October and November have been strong, however – more than 200,000 new jobs each month -- numbers that put tapering squarely back on the table.

The timing was believed to be right for tapering because the Fed has been telegraphing a reduction in its easy-money programs for months but has held off until the economy showed sustained momentum. Conventional wisdom in the fall held that a sharp market selloff would follow a tapering announcement, as investors mourned the loss of easy money. But the likelihood of that happening has been decreasing because markets have been pricing in tapering.